The Flaws in Demand & Supply thinking

Monday 8 August 2011

Let me start by saying that my Masters of Science qualification is NOT held in economics and with that said I'm holding an interested person's perspective toward wanting to know 'why' and 'how'. I have some questions and thoughts about the theory of Supply and Demand and would be happy to have some feedback from people with more expertise than I have, should any of my thinking be in need of remedial catch-up.
My understanding of Demand & Supply is as follows - In cases where there is high demand and low supply of any particular item or commodity, the demand supply theory says that prices for that item are likely to increase. And in cases where there is high supply and low demand, it is likely that prices for that item will decrease. A key thing here to note is that in any situation, they don't HAVE to increase or decrease, it's just that some people aim to gain as much as they can when the moment arises and so, people raise or lower their prices in step to a perception of times being good or otherwise.

If I have that theory understood (and I may not have, I'll await your input) then as an everyday person in the street I have a series of thought bubbles going off in my head at the minute. Why is it, for instance, that in the case of say Private Health Insurance, when demand drops (people choosing to no longer remain customers of a private health insurance provider) the price for everyone else goes up? I don't understand why a business would penalise the loyal supporters they have. Surely, if I'm understanding supply & demand theory well enough, when more customers drop out, that means less demand which means pressure for lower prices. Or does demand & supply work differently when the item or commodity in question is a 'service' as opposed to a product?

And right now I'm hearing in the media, suggestions that costs of borrowing money is likely to increase which I guess is reflected in an increase in interest rates. But here in Australia, we know that business borrowings are flat - there has not been a significant upturn in businesses borrowing post GFC Mk1. We know that banks are hoping that domestic borrowing will pick up some of the slack though likely to be far less in volumes. So if there is low demand and significant supply, doesn't that mean that following demand and supply theory we would see a pricing DECREASE for borrowings? Surely right now, banks would be going out of their way to entice people to borrow? Mmm, perhaps I'm missing something.

If we add in that the sense that there is another economic challenge in the wings and that this then leads to a PERCEPTION of increased defaults of loan payments, that would then lead to a decrease in supply in available financing as some lenders withdraw from the market. So what then happens when supply is thin and demand is low? Surely that means things stay stable?

Or what about retail businesses who have for years (by and large) ignored investing in staff training such that customers no longer understand there is a real value to shopping in person? Having (arguably I grant you) taught the consumer (through poor attention to staff training) that if you get the same level of service face to face as you do on line (i.e almost none), then many retailers have (unintentionally) managed to shift consumer attention towards a lower cost version of a 'no service' business model. Now I'm hearing that some retailers intend to pass on costs to customers as a result of any Carbon Tax. Maybe that's a good thing, maybe not and I know one thing, consumers will vote with their feet and their wallets. If demand is low, and you increase the prices (much like the Health Insurance customers experience), surely that only encourages people to leave? Does the retail industry experience a different version of supply and demand theory than the rest of us?

Now forgive me for having a lay person's understanding of economic theories, and I just don't understand how anyone can be suggesting that there needs to be an increase in the Reserve Bank's cash rate when demand for cash is low. And forgive me for ignoring the idea of 'amortisation' wherein a Health Insurer spreads their risk across everyone and increases their prices to customers because they have inflexible business models or aren't willing to find an effective way to not only retain, but attract more customers (the clue by the way is by insuring for health, not against sickness). And please accept my apology for thinking that it is the responsibility of the reatiler to 'show cause' as to why their offering is better than someone else's, online or otherwise

So are there fundamental flaws in the Supply & Demand theory, or just flaws in my understanding of it? Or is it something else?

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